DP12742 | Loan Contract Structure and Adverse Selection: Survey Evidence from Uganda

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While adverse selection is an important theoretical explanation for credit rationing it is difficult to empirically quantify. One reason is that most studies measure the elasticity of credit demand of existing or previous borrowers as opposed to the population at large. We circumvent the issue by surveying a representative sample of microenterprises in urban Uganda and present evidence of adverse selection in two key dimensions of credit contracts - interest rates and collateral requirements. Theory suggests that a lower interest rate or a lower collateral obligation should increase take up among less risky borrowers. Using hypothetical loan demand questions, we test these predictions by examining if firm owners respond to changes in the interest rate or the collateral requirement and whether take up varies by firms' risk type. We find that contracts with lower interest rates or lower collateral obligations increase hypothetical demand, especially for less risky firms. The effects are particularly strong among manufacturing businesses. Our results imply that changes to the standard microfinance product may have substantial effects on credit demand.